Southwest Airlines Co. Wants You to Know It's Still a Low-Cost Carrier

Southwest Airlines (NYSE: LUV) made its name as America's undisputed low-fare leader. But over the past decade or so, its cost (and price) gap with legacy carriers like Delta Air Lines (NYSE: DAL) has narrowed. Meanwhile, a set of "ultra-low-cost carriers" -- led by Spirit Airlines (NASDAQ: SAVE) -- have become the new price leaders.

As a result, a number of media outlets have questioned whether Southwest is really a low-cost (or low-fare) carrier. Other stories have asked whether the "Southwest Effect" (which consists of a decrease in fares and an increase in traffic in markets that Southwest enters) is dead.

Is the "Southwest Effect" dead? Photo: The Motley Fool

Last week, Southwest finally responded. The carrier released a detailed report, claiming that despite the improved competitive position of legacy carriers and the rise of ultra-low-cost carriers, "The Southwest Effect Is Alive and Well." Is this true, or is it just corporate spin?

A new ballgameIn the last years before the Great Recession, Southwest Airlines was a disruptive force within the airline industry, offering dramatically lower fares than rivals. It was able to do this for two reasons.

Legacy carriers like Delta have cut costs through mergers and bankruptcies. Photo: The Motley Fool

First, legacy carriers such as Delta Air Lines (which became the world's largest carrier in 2008) had higher cost structures. For example, in Q4 2008, Southwest's cost per available seat mile excluding special items and fuel was $0.0664. Delta's mainline CASM excluding fuel and special items was $0.0722: about 9% higher.

Second -- and most importantly -- Southwest had made a shrewd long-term bet on oil prices and benefited from substantial fuel hedge gains in the last years before the Great Recession. In 2008 alone, Southwest reported $1.1 billion of fuel hedge gains on $11 billion of total revenue. This kept it profitable in 2008 even as other airlines plunged deep into the red.

Today, Southwest is paying essentially the same jet fuel price as everyone else, as its below-market fuel hedges have expired. Furthermore, its own costs have gradually risen while its top competitors have reduced their costs through bankruptcies and mergers. In Q1, Delta's mainline CASM excluding special items (but including fuel) was approximately $0.14: less than 10% higher than Southwest's CASM excluding special items of $0.1288.

Spirit Airlines has a much lower cost structure than Southwest. Photo: Spirit Airlines

Additionally, Spirit Airlines and other ULCCs have stepped in with even lower cost structures. Spirit has cut unit costs through measures like putting more seats on each plane and maximizing aircraft utilization. Spirit's Q1 CASM was just under $0.10 -- more than 20% below Southwest's CASM.

Has Southwest been framed?In its "manifesto" and the accompanying slideshow released last week, Southwest Airlines essentially argues that it has been framed. While the company admits that it's not the cheapest option on every route it flies, Southwest claims to offer the lowest base fare about 56% of the time.

On top of that, Southwest has much lower fees than most of its competitors -- whether they be legacy carriers or ultra-low-cost carriers. Southwest points out that it allows two free checked bags (a savings of up to $120 round trip vs. the legacy carriers) and does not charge change fees (the typical legacy carrier change fee is $200).

Southwest's presentation also looks at several markets that Southwest has entered within the last few years, such as Charleston, S.C., Memphis, Tenn., Wichita, Kan., and Flint, Mich. Southwest shows that its entry into these markets consistently results in lower fares and higher passenger traffic.

What gives?How do the data look so different to Southwest Airlines on the one hand and a variety of industry analysts on the other? There are a few key points to keep in mind.

First, airlines do not set prices in a vacuum. When an airline holds a monopoly -- or a near-monopoly -- on a nonstop route, it will typically set fares high in order to earn a big profit margin. But if a competitor starts serving the same route, the former monopolist will be forced to lower its prices in order to avoid losing most of its customers.

As a result, it's possible for Southwest's entry into a new market to dramatically reduce fares even if the legacy carriers match Southwest's fares on routes where they compete directly. The before and after comparisons offered by Southwest are more meaningful than the direct price comparisons used by many critics.

Southwest still helps keep fares down in the markets where it competes. Photo: The Motley Fool

Second, ultra-low-cost carriers are still a tiny fraction of the U.S. airline industry. Last year, Spirit Airlines -- the most prominent ULCC -- had 90,284 departures, compared to more than 1.3 million at Southwest. In terms of available seat miles, the gap was somewhat smaller, but Southwest's capacity was still nearly 10 times higher.

Indeed, Spirit flies most of its routes just once a day. This means that only a small portion of the travelers flying a particular route can actually take advantage of its low fares. It also means that competitors are less likely to match Spirit's prices, because Spirit typically does not offer enough seats to significantly dent its competitors' market share.

Lastly, it's virtually impossible to avoid all of the fees on an ultra-low-cost carrier. As a result, it's virtually meaningless to compare a ULCC base fare to an all-inclusive Southwest Airlines fare.

Foolish bottom lineThere's no question that the cost gap between Southwest Airlines and legacy carriers like Delta Air Lines has shrunk noticeably in the last five to 10 years. Furthermore, ultra-low-cost carriers like Spirit Airlines do have significantly lower unit costs than Southwest.

That said, Southwest is still the low fare policeman of the U.S. airline industry. Only Southwest has the resources and willingness to step in and offer a meaningful level of service in markets plagued by high prices. Southwest's fares may not be as low as they once were, but without Southwest Airlines, ticket prices would be much higher.

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